Low Income Housing Tax Credits

“I’ve been given the hard sell by a Honolulu financial advisor on a limited partnership in Low Income Housing Tax Credits (section 42 federal tax code). He claims this investment to be the greatest tax credits since the invention of electricity. Do you agree, or is this another repackaged 70’s style shelter with no merit? I’m told that for a $10,000 investment into a Low Income Housing Tax Credit limited partnership, I can get a $1300 tax credit per year for 10 years. Return of principle is in doubt as the property may be worthless at the end of the holding period. The financial advisor pushing this tells me not to be concerned about that because the ‘internal rate of return’ is great. All I know is that if my $10,000 disappears all I have is a $3000 return after 10 years. Is internal rate of return a good measure of an investment?” — Carl Paradise

I’m no expert in this and haven’t seen your particular deal, let alone the real estate in question (have you?), but let’s start with the easy part — the math. And the first thing to say here is that, yes, internal rate of return is a good measure of an investment. In fact, properly calculated, it is the only proper measure. (It’s kind of like asking: “Is height a good measure of how tall someone is?” Except you need a financial calculator, not just a tape measure, to determine it.)

So what is the internal rate of return on this investment?

If you wind up losing the $10,000, then to have received 10 annual $1,300 “payments” by way of tax credit is to have “earned” almost exactly 5% a year on your money. If you get the $10K back at the end of the 10 years, but no more, your internal rate of return jumps to 13% a year. And of course if the value of this real estate zoomed — which it may not because it is low-income housing with, I presume, rent caps — then your return would be even higher.

The tax credits, I’m told, are real — this isn’t some wild bull semen tax shelter from the Seventies. (In the Seventies, the top federal tax bracket was 70%, so people would jump at anything.) But there may be other ramifications and pitfalls that make the worst case worse than the aforementioned 5%. One, I suppose: the possibility that you might not need a tax credit some year, rendering it valueless. Another: the possibility that you’ll spend a little extra time and money each year on tax preparation. The biggest: If the general partner should fail to perform as required by the law that set all this up, it’s possible that the tax credits would be disallowed or even “recaptured” (meaning you have to pay them back, with interest and penalties).

Not to deal your financial advisor out of the $700 or $800 he might get from each $10,000 you invest in this . . . it could work out just fine. But if it makes you at all nervous, I wouldn’t do it.